Billionaire John Paulson's top small-cap picks

Ms. Krishnamsetty is editor and co-founder of
Insider Monkey, a finance website
that provides free insider trading and hedge-fund stock-holdings data. Her
articles draw upon the research and analytics of co-founder Dr. Ian Dogan,
Insider Monkey's research director, who holds a Ph.D. in financial economics
with a specialization in insider trading. Dogan has provided consulting services
to institutional investors and hedge funds, and managed a $200+ million fund
using a strategy he developed tracking
insider transactions.
Dogan authored the insider trading chapter of the soon-to- be-published “The
Handbook of Investment Anomalies” by Zacks Investment Research. Prior to Insider
Monkey, Krishnamsetty worked for Bloomberg Television, CNBC, NPR and in risk
management at Marsh & McLennan. Krishnamsetty has an M.S. in Journalism from
Columbia University’s Graduate School of Journalism.

Most small-cap companies don't get much attention in the media or the blogosphere, which often leaves them less efficiently priced than their larger peers. As one can expect, hedge funds take advantage of this phenomenon by dedicating their research teams to work on these stocks, generating a significant portion of their alpha in the process.

Retail investors can use hedge funds' top small-cap picks as a market-beating strategy; we've determined that the most popular small-caps among hedge funds can earn about 120 basis points of alpha per month (check out the details here).

With this in mind, we're going to take a look at one fund in particular: John Paulson's Paulson & Co., which is mammoth in its size at nearly $12.7 billion. At first glance, John Paulson would appear to be one hedge fund manager that retail investors should avoid. After all, he has gained quite the reputation over the past two years for returns that have his clients red in the face.

It's crucial to point out, though, that these issues are predominantly the result of his large investments in mega-cap stocks, in addition to his macro views. Like David Einhorn (see Einhorn's Huge Secret), Paulson's smaller positions have performed very well historically, proving that it's profitable to mimic these picks. We’re going to look at his top five. As is consistent with our strategy, each stock listed here had a market capitalization between $1 billion and $5 billion at the end of the third quarter.

According to his latest 13F filing with the SEC, MetroPCS Communications
US:PCS
is John Paulson's top small-cap holding, sitting at the No. 10 spot in his overall portfolio. MetroPCS is up over 47% in the past six months, and at first glance, these gains appear to have come from positive sentiment surrounding the company's announced merger with T-Mobile USA. Since news of this deal broke on Oct. 3 of last year, however, shares of MetroPCS have actually lost 28.3%.

The deal, which is expected to close in the first half of this year, will gradually transfer customers from MetroPCS to T-Mobile, with the former's network set for complete shutdown by 2015. The company is coming off of two consecutive colossal earnings beats and will report its 2012 fourth-quarter financials at the end of next month.

With a price/earnings-to-growth ratio below 0.5 and 13 times year-ahead EPS, shares of MetroPCS are undoubtedly cheap, but with rumors of a bidding war between T-Mobile and Sprint still fresh, it's possible some investors are uncertain what the future will hold. Still, at these levels, it's hard not to mimic Paulson's bullishness. Billionaires Steve Cohen and James Dinan are among the hedge fund managers who are bullish on PCS.

AMC Networks Inc
AMCX, -1.61%
the broadcast and cable TV company, is Paulson's second-favorite small-cap, and is also a top pick of Christian Leone's Luxor Capital. AMC Networks' best asset is its original programming, which has generated double-digit viewership growth for shows like “Breaking Bad” and “The Walking Dead,” and the company is coming off a third-quarter earnings beat more than 25% above Wall Street's estimates.

Despite appreciating more than 16% in 2013 alone, shares of AMC Networks are still fairly valued at 18.6 times forward EPS and an earnings growth multiple below 1.4. Furthermore, even though the company does not pay a dividend, there's more than enough growth here — the sell-side expects 33%-34% EPS expansion next year alone — to warrant further support from momentum-seeking investors.

Next up we have CNO Financial Group Inc
CNO, +0.83%
the mid-sized holding company for the insurers Washington National, Colonial Penn Life, Bankers Life and Casualty, and Conseco Insurance. A fixed-income investment advisory firm, 40/86 Advisors, is also a subsidiary of CNO.

On the whole, shares of the holding company have risen by 28.6% in the past six months and still trade at a measly forward P/E of 10.0x. This discounted valuation is a result of the sell-side's extremely bullish EPS forecasts in excess of 40% growth next year, and Wall Street's average price target on the stock represents 10% upside from current levels.

CNO pays a projected dividend yield of 0.8% at the moment, but it's quite possible we'll see a payout hike in 2013. Zacks, for one, recently upgraded the stock to an "Outperform" rating, partially due to the "prospects of significant capital deployment." Billionaire Israel Englander sold more than 90% of his position in CNO during the third quarter.

Paulson's fourth-largest small-cap holding is NovaGold Resources
NG, +0.24%
As its name suggests, NovaGold is primarily focused on gold discovery and extraction, with operations in Alaska and western Canada. Shares of the company have fallen 17.7% since July 26 of last year, when Barrick Gold Corp (ABX) announced that the duo's joint-owned Alaskan Donlin Creek project "no longer meets its investment criteria."

This news essentially trounced any bullish thesis of NovaGold related to its Ambler spinoff earlier in the year, but it's worth noting that optimism over the company's efforts to sell at least 50% of its Galore Creek stake is riding high at the start of 2013. Wall Street expects earnings to double this year, and analysts' average price target on the stock represents an appreciation of more than twofold, so it's clear why Paulson is long.

At the end of the last 13F filing period with the SEC, Paulson held shares of Gaylord Entertainment, making it his fifth-largest small-cap holding, sitting at the No. 16 spot in his 13F portfolio. Gaylord has since converted into REIT status effective at the start of 2013, and can now be traded as Ryman Hospitality Properties, Inc.
RHP, +1.53%
Ryman has gained 4.6% since this reclassification became official, and currently offers value to investors at two times its book value — less than half that of the industry's average of 4.4x.

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